1. Chapter 10: Aggregate Demand I

2. The IS-LM Model
A short-run macroeconomic model which takes the price level constant and shows how changes in the level of Aggregate Demand cause changes in income.
The IS curve: The Keynesian Cross Theory
The LM curve: The Liquidity Preference Theory

3. Shift in Aggregate Demand
An increase in the level AD increases
the level of income, given the price level.
Price level P
SRAS
AD3
AD2
AD1 Y1 Y2 Y3
Output, Income

4. Total income = Total planned expenditures
The Keynesian Cross
Equilibrium in the product market:
Planned Expenditures: E = C(Y-T) + I + G
Actual Expenditures: Y
Aggregate Equilibrium: Y = C(Y-T) + I + G
Total income = Total planned expenditures

5. Aggregate Equilibrium
Actual Expenditure: Y = E E
Planned Expenditure:
E = C + I + G
Keynesian Cross
Increase inventories
Reduce inventories Y2 Y Y1 Y

6. Adjustment to Equilibrium
Y1> Y indicates an excess supply of goods in the market. So, businesses accumulate inventories to reduce Y1 to Y
Y2<Y indicates an excess demand for goods in the market. So, businesses reduce inventories to increase Y2 to Y

7. Effect of Stabilization Policy
A government policy of changing planned expenditure, C, I, or G, would shift the Planned Expenditure line to increase the level of income.
The increase in income is subject to a multiplier effect as spending by consumers receiving the new income, creates income for other consumers

8. Effect of Government Spending Policy
Y = E
E = C + I + G2 E ΔG
E = C + I + G1 B A ΔY Y1 Y2 Y

9. Government Spending Multiplier
ΔG = Increase in government purchases
ΔY = Increase in income
Multiplier effect: ΔY / ΔG = 1 / (1 – MPC)
Example, MPC = 0.6, Spending Multiplier = 2.50; Any $1 increase in G creates an additional $2.50 of income

10. Effect of Government Tax Policy
Y = E
E = C2 + I + G E ΔC
E = C 1+ I + G B A ΔY Y1 Y2 Y

11. Government Tax Multiplier
ΔT = Decrease in income taxes
ΔC = Increase in consumption = -MPC * ΔT
ΔY = Increase in income
Multiplier effect: ΔY / ΔT = -MPC / (1 – MPC)
Example, MPC = 0.6, Tax Multiplier = -1.50; Any $1 decrease in T creates an additional $1.50 of income

12. Derivation of IS Curve
IS shows level of income and interest rate that bring about equilibrium to the product market
Assume an initial income level and interest rate. An increases in interest rate reduces planned investment. Then, the Planned Expenditure line shifts down, causing income to decline.

13. IS Curve Interest rate IS shows pairs of income and interest rate
such as (Y1, r1) and (Y2, r2) that bring
about equilibrium in the product market.
The higher the interest rate, the lower the
level of income. r2 B A r1 Y2 Y1
Income

14. Shift of IS Curve Interest rate
An increase in planned expenditure (C, I, or G)
causes the IS to increase, hence increasing the
level of income through the multiplier effect.
IS2
IS1
Income Y1 Y2

15. Theory of Liquidity Preference
Equilibrium in the money market
Demand for money: (M/P)d = L(r,Y)
Money supply: (M/P)s = M/P
Equilibrium: M/P = L(r, Y)

16. Money Market Equilibrium_
M/P r r1
L(r, Y)
M/P

17. Derivation of LM Curve
An increase in the level of income causes the demand for money to increase. As a result of a higher demand for money, the interest rate goes up
The higher the level of income, the higher is the rate of interest

18. Derivation of LM Curve _ M/P r LM r2 r2 r1 r1 L(r, Y2) L(r, Y1) Y1 Y2
LM shows pairs of income and interest rate such as
(Y1, r1) and (Y2, r2) that bring bout equilibrium
in the money market. _
M/P r LM r2 r2 r1 r1
L(r, Y2)
L(r, Y1) Y1 Y2
M/P

19. Shift in LM Curve LM1 M1/P M2/P r LM2 r1 r1 r2 r2 L(r, Y) Y M/P
An increase in the money supply, lowers the
interest rate, making the LM curve to increase.

20. Aggregate Equilibrium
Aggregate equilibrium is achieved when IS = LM
IS: Y = C(Y - T) + I(r) + G
LM: M/P = L(r, Y)

21. Aggregate Equilibrium
Interest rate LM r IS Y
Income

22. Theory of Short-Run Fluctuations
AD Curve
Keynesian
Cross
IS Curve
Short-run
Fluctuations:
Income
Interest
Rate
AD-AS
Model
IS-LM
Model
Theory of
Liquidity
Preference
LM Curve
AS Curve